Reducing our European equity overweight

Market analysis
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11/18/2016

Markets continued to play the Trump reflation trade, especially in the US.

As a result, US equities outperformed other markets apart from Japan while US Treasuries fell further, dragging down other sovereign bonds in their wake. And the US dollar made further sharp gains against other currencies.

Amid uncertainty over the shape of future US policy, there was little news on fundamentals to change the picture but data releases suggested the US economy (before the elections) was still improving. Both the University of Michigan’s household confidence indicator for November and retail sales came in better than expected while weekly unemployment claims continued to fall.

We have recently modified our asset allocation by:- reducing our European equity overweight from + to =/+- closing out our US Treasury underweight

Equities are facing two risks:

(i) as has sometimes been the case in the past, the speed and force of bond market shifts could end up dragging down other asset classes.

(ii) the Brexit vote and Donald Trump’s election have made investors nervous ahead of a series of elections in Europe. Sovereign spreads have widened sharply but have so far had little impact on European equities but that could change in December after the Italian referendum.

We have also taken profits on our US Treasury underweight but have maintained hedges on the short end of the yield curve as we still think the risks from the Fed’s looming rate hike have not been fully priced in. At the long end, markets are now priced for average inflation of 2% over the next 10 years, an assumption which strikes us as reasonable.

Generally speaking, markets have adjusted to a more reflationary scenario following Mr Trump's election, a move which is in tune with our asset allocation stance. But it is, for the time being, very tricky to predict which policies will effectively be rolled out and this uncertainty warrants a premium. Following these big market moves, risks now look more symmetrical and although our allocation remains pro-cyclical, we think a more cautious bias is called for.

European equities

In the week following the US election, European markets were calmer, ending the period slightly higher after the Fed chair's statements on future monetary policy. The earnings season approached its end. Results were generally positive with 60% of companies beating estimates. However, there was no inversion in the earnings revision trend for 2016 as a whole and for 2017.

Allianz reported strong third-quarter figures across all divisions: asset manager Pimco saw net inflows, non-life insurance surprised positively after a disappointing second quarter, and life assurance also beat expectations. Bouygues had a good quarter for new subscribers to its telecom services, especially in mobiles (fixed line figures were somewhat stable). Margins improved in construction and the group reiterated its annual guidance. Iliad won new customers in fixed and mobile telephony and quarterly sales rose 6.5% or more than expected.

L’Oréal also beat expectations thanks to strong sales, especially in makeup. Difficult zones like Brazil and Russia saw some improvement but the situation remained more complicated elsewhere, notably in France and China. Merck’s figures were in line but the group raised its guidance for Ebitda and EPS in 2016. CRH reported figures in line. Rolls Royce widened its restructuring objectives for 2018 and said 2017 would be a mixed bag.

In a quiet week for capital transactions and reorganisation, LVMH unveiled a EUR 300m share buyback representing 0.36% of its equity which will run until December 30 2016. This is less than the EUR 1bn programme initially expected. Publicis said it was merging its Sapient and Razorfish networks and housing them in a structure dedicated to the group's digital assets.

US equities

It was another up week for markets as indices flirted with historic highs. The S&P gained 1% to 2,187, just shy of the all-time high of 2,190, while last Tuesday, the Dow Jones hit its highest level ever. The trend was essentially due to hopes of inflation reviving thanks to Donald Trump's stimulus programme and his planned cuts to corporate and household taxation. October’s retail sales rose by 0.8%, after rising 0.6% in the previous month, and capacity utilisation remained flat at 75.3%. CPI was similarly unchanged at 1.6%.

The big talking point was the sheer violence of sector rotation over the week. Expectations of inflation returning sent yields on US 10-year Treasuries up to 2.3% and Janet Yellen underpinned the trend by saying she was in favour of raising rates in the short term.

As a result, financials continued to rally, adding 4% over the week and taking gains since the election result to 14%, a movement that was also fuelled by the prospects of reduced regulatory pressure. At the same time, consumer staples and utilities lost between 4% and 6% as bond yields rose.

Japanese equities

Over the week, the TOPIX advanced 3.4% as Japanese equities rallied on buoyant US markets and the falling yen. President-elect Donald Trump's policies are expected to lead to higher interest rates and US dollar strength. The increasing prospect of a US rate hike in December also pushed the yen lower, boosting Japanese exporters. Foreign investment in Japan’s stock markets has also accelerated since Trump’s election victory.

Financial sectors including Banks (+12.6%) and Insurance (+10.3%) were this week's top gainers. In contrast, Fishery, Agriculture & Forestry and Foods retreated by 1.5% and 0.8% respectively.

Japan’s top banking groups posted significant gains on expectations that banking regulation would be relaxed as well as upward earnings revisions on the prospect of higher interest rates. Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group and Mizuho Financial Group jumped 20.8%, 13.5% and 12.1% respectively.

Emerging markets

Emerging markets saw commodities and stocks fall as the US dollar remained strong. The dollar sprinted to a more than 13 and- a-half-year high against a basket of major currencies at the end of the week.

In an effort to lower the coal price, the Chinese Government has decided to increase production days from 276 to 330. The Chinese currency reached an all-time low of 6.8881 to the dollar, a year to date decline of 6.2%.

Tencent, China’s internet giant, reported a 52% surge in third-quarter revenue growth while earnings jumped 40% YoY. Advertising revenues were softer than expected but growth was driven largely by the massive success of Tencent’s WeChat messaging application and its mobile gaming business. The Chinese online direct sales company JD reported USD 9.1bn in revenue for its September quarter which was much better than expected.

Korea’s Samsung agreed to buy Harman International in its biggest overseas acquisition ever. The deal will lift Samsung into the top ranks of auThe

The deal will lift Samsung into the top ranks of auto technology suppliers and immediately establishes a strong foundation for Samsung to grow its automotive platform and provide access to connected ecosystems. Samsung hopes to marry its fast microprocessor and software technology with Harman’s infotainment and vehicle systems, a bet that growth after smartphones will be in electric vehicles.

India's retail inflation cooled to a 13-month low in September, helped by moderating food prices and giving the central bank room to cut interest rates again if needed. The consumer price index (CPI) rose 4.31% last month from a year earlier, its slowest pace since August 2015.

Brazilian services volume declined by 0.3% in September, following a 1.4% drop in August.

Mexico's peso fell on Thursday after its central bank announced a less-than-expected rate increase. Investors wanted stronger action to counter a slide in the currency sparked by Donald Trump's US presidential election win.

In Russia, industrial production came in better than expected, dipping 0.2% YoY. This was an improvement on the minus 0.8% seen in September.

Commodities

Oil rebounded to above USD 45 amid indications that talks between OPEC members were going in the right direction. Bloomberg reported that Saudi Arabia had defined 4 pillars as a basis for an agreement: 1) collective participation 2) a fair effort from each country on production cuts 3) transparent proceedings and, 4) a deal that would look credible to financial markets. The Saudi oil minister remained optimistic on the chances of an agreement and asked cartel members to target the 32.5 million b/d floor announced in Algiers (according to the IEA, the cartel produced 33.64 million b/d in September).

We view this figure as ambitious given recent production increases from cartel members like Iraq and Iran but its success would mean a sharp rise in oil prices and help Brent crude break out of the USD 40-50 trading range it has been in since April. But then sharply higher US weekly inventories arrived to cap the oil price rally. It would appear that US producers have preferred to stockpile so as to hedge against any price increase after the November 30 OPEC meeting.

Base metal prices fell due to the stronger US dollar and sentiment that the post-election rally based on reflation and infrastructure projects had gone too far. China eased the restrictive limit of 276 days a year for coal mine operations which had sent coal prices surging and caused an 11% fall in output between January and the end of October. Mines can now operate for 330 days a year. Thermal and metallurgical coal prices plunged on the news.

Gold lost further ground. This was due to the rising US dollar but also India’s decision to withdraw RS 500 and 1,000 bank notes, or 86% of banknotes in circulation, to fight against money laundering. The move hit demand for physical gold.

Corporate debt

Credit

This week saw fresh volatility on corporate debt markets. Due to expectations of higher inflation and steeper yield curves, investors reduced duration in their portfolios. Last Monday for example, the correction was sharper on cash credit than on the Xover which tightened by a mere 1.5bp or on equities (the EuroStoxx actually gained 0.35%).

Over the week, the Xover traded around 350bp. Italy could play the trouble maker next month due to the December 4 referendum. The latest polls put the “no” vote at 52% against 48%. A “no” victory could weigh even more on corporate risk premiums in Italy. Companies like Telecom Italia, Fiat and Saipem have been underperforming the rest of the high yield universe.

In M&A, Liberty Global’s managing director said that the joint venture with Vodafone in the Netherlands was probably not the ideal template for any other agreements between the two groups in Europe. He added that there were no other talks between them for the time being.

Elsewhere, Bridgepoint is in exclusive talks with Elsan for the sale of MédiPôle Partenaires. Bombardier launched a new USD-denominated bond sale to refund some of its 2018 bonds.

Tereos released upbeat first half results for the FY 2016/17 as the group continued to enjoy a rebound in sugar prices. EDF’s board has approved a firm bid for Areva’s reactor division. Astaldi and Obrascon won a USD 1.2bn contract to improve the I-405 highway in Los Angeles. ABN AMRO announced a fully loaded and phased-in CET1 ratio of 16.6% (+40bp over the quarter). The bank also unveiled its SREP requirements for 2017: required CET1 will be 9%, down from 10.25% of 2016. ING sold USD-denominated Tier1 debt with a coupon of 6.875%.

Convertibles

After two quiet weeks, the convertible bond primary market returned with four new issues. Bayer was the main focus as the company came to market with EUR 4bn in 5.625% 2019 mandatory convertible notes. The company’s intention to issue convertibles had been common knowledge since May but the timing was something of a surprise since the closing of the proposed Monsanto purchase is not expected until the end of 2017.

In France, SEB successfully issued EUR 150m in zero coupon 2021 ORNAEs (bonds which offer the option of being reimbursed in cash or in equity) with the proceeds being used to partially refinance the acquisition of the German group WMF (the country’s leader in professional automatic coffee machines).

In the US, PDL BioPharma, a pioneer in the humanization of monoclonal antibodies, agreed to sell USD 150 million in 2.75% convertible bonds due 2021, using the net proceeds to repurchase part of its outstanding 4% 2018 CB.

AMD shares rallied almost 25% in three days following strong results from competitor Nvidia and Google’s plan to integrate the company’s GPU server solution into its cloud platform.

Privately-held Spanish brewer Damm announced its intention of issuing EUR 200m in bonds at 1% due 2023 which are exchangeable into Ebro Foods, a multinational food group making pasta, rice and sauces.

Brait SE reported a first half 2016 loss of ZAR 4.5bn owing mainly to sterling weakness. In addition, CEO John Gnodde said that the plan to transfer the company’s head office to the UK from Malta would be put to a shareholder vote on November 22, along with a new fundraising round to cover future investments.